Monday, December 28, 2009

Complicated CDO Pricing Did Not Create The Banking Crisis

A comment I posted on Felix Salmon's Reuters blog, "It’s impossible to price a CDO" that blames the inability to compute CDO prices and Goldman Sachs for the financial crisis.

All derivatives, futures, options and swaps are zero sum. One counterparty’s gain is the other party’s loss. CDOs behave as any other derivatives behave when it comes to winners and losers.

For many years, farmers have used agricultural derivatives purchased at planting time to protect themselves from the uncertainty about crop yields and prices at harvest time. Speculators, investors and food companies are the counterparties to the farmers.

All the computers in the world combined and all the supercomputers cannot accurately predict harvest time prices. Weather, droughts, floods, hurricanes, frost, crop diseases, foreign growers internal country politics, wars, tariffs, strikes, oil price spikes, e coli and salmonella outbreaks and other price effecting events are too unpredictable to know with any degree of uncertainty in advance.

Yet, the agricultural derivatives markets work very well and without the ability to compute future outcomes.

There is much more to the CDO problem than nuclear waste mortgages and computational difficulties.

Financial nuclear waste sells all the time without blowups as occurred in the mortgage market. Investors with high-risk tolerance buy, invest in and trade debt of bankrupt companies, junk bonds of very low credit rated companies, start-ups, and other high risk, high probability of default debt all the time.

Financial markets exist for all kinds of debt with high degrees of uncertainty about future events and with high likelihood of defaults without major problems.

If Goldman was selling snake oil, there was nothing compelling the buyers to buy and invest in the snake oil. Was Goldman holding a gun to each investor and buyer’s head of the CDOs?

Furthermore, and a more compelling argument, is that US Treasury bonds of all maturities from a few days to 20 years was available to the same investors who purchased Goldman’s so called nuclear waste. When there was a safe, transparent alternative investment that all the buyers knew about, why did they buy CDOs? US Treasuries are better than AAA rated!

Additionally, private equity, hedge funds and mutual funds were not the investors who ran into problems purchasing CDOs, (the mutual fund that broke the buck was a higher risk fund that attempted to increase its yield by heavily investing in higher risk securities like mortgage derivatives and just because it called itself a money market fund the Fed panicked).

The banks, who are sophisticated investors, suffered the most losses from the CDO market collapse.

What really went wrong for the financial institutions from the collapse of the CDO markets due to excessive mortgage defaults was that the financial institutions were overly invested in these kinds of debt.

Market prices collapse all the time for different kinds of investments, be it Gold, foreign currencies, commodity prices, etc. There is one simple rule of investing that has stood the test of time and does not need a lot of computer power. The rule is DO Not Put All Your Eggs In One Basket. The banks were not diversified. They bet the bank on mortgage related debt and they lost. They were gamblers that put everything on red on the roulette wheel and black came up.

Why banks did it is a whole other discussion, but Goldman was not the cause. Yes, it had the product that blew up, but it id not create the hunger in the buyers and investors for that product. Goldman met the banks cravings for these investments, but it id not make the banks the junkies that they were for this crack.

If the CDO outcomes were not computable by the buyers, then the CDO outcomes were not computable by Goldman. Goldman could not know in advance that it would see windfall gains.

Furthermore, the CDOs that ran into the most problems were the ones originated after the housing market started to collapse and that data was publicly available to the investors, including as to which areas of the US were seeing the sharpest price declines. Plus, the investors knew or could easily ask Goldman and Goldman would tell them which areas of the country had the mortgages in the CDOs they were buying.

Most of the responsibility for the problems should go the regulators. They overlooked the lack of diversification and the overinvestment in mortgage derivative debt. They promulgated rules that allowed banks to hold for each dollar of capital against a residential mortgage, two and one half times as much CDO mortgage debt. The regulators, through capital rules that promoted capital arbitrage, turned banks into crack heads for CDOs and then failed to supervise their addicted banks.

Goldman was like a bartender. It had a secondary and not a primary responsibility. It did not create the alcoholics, but at some point, it should have seen that the regulators were not stepping up to the plate and that their customers were in over their heads and too drunk to drive anymore. However, the regulators created the drunken banks and not Goldman. Goldman was at worst opportunistic.